How Do Forex Exchange Rates Work?

In this tutorial, you'll learn about the factors that make Forex exchange rates move. It's really important to understand why and how Forex exchange rates move because you'll deal with market fluctuations every day.

You don't want those moves to seem scary right? The more you understand about Forex trading, the better a Forex trader you'll be. 

Understanding Forex Exchange Rates 

  • To understand currency fluctuations, let’s assume you've had Euros parked in your local bank account for a year. Your bank will pay you a certain percentage of interest. The interest rates vary from currency to currency, for example, the annual interest rate on your deposit in Euros in a German bank might be 3.5 percent. 

However, another person in the UK might be getting 6 percent interest on his deposit in British Pounds. So to take advantage of higher interest rates of British Pound you'd want to sell the Euros and buy the Pounds.

The world is so big and you'll not be the only person keeping on the interest rates. Large organizations, banks, and individuals would do the same. Now if a big amount of Euros is exchanged for the British Pounds, the Euro is likely to get weaker.

The reason for this is because decreased demand for the Euros will drive its price lower. At the same time increasing demand for British Pound will drive its price higher.

So this is one of the basic factors that affect currency prices. And it affects Forex exchange rates as well.

Forex Exchange Rates

1. Market News & Economic Indicators

Another example that relates to currency fluctuation is the release of market news. For instance, a financial report shows instability in Eurozone and indicates that the unemployment rate is rising. In fact, the companies are posting negative growth. 

The news will alert the investors and financial institutions and they may start selling the Euros. As a result of selling pressure, the Euro will become weak against other currencies.

A significant point of view is that the better the picture of a nation or a group of countries representing a currency, the better the currency becomes in the long run.

Especially against the other currencies. It's important to understand Forex exchange rates. It can help you better invest in the stock market.

2. Economic Indicators

There are several economic indicators that affect the currency value of a nation. Some of these indicators are the unemployment rate, inflation, interest rates, GDP, retail sales, industrial production, consumer price index (CPI), housing numbers, trade balance, and so forth.

Investors use these indicators to evaluate the currency value of a country. The US dollar is the most dominant currency in the Forex market and Forex exchange rates.

As a result, investors pay special attention to the US indicators that are released weekly, monthly, and quarterly by various sources. Some of these sources include The Federal Reserve Board, the US Bureau of Labor Statistics, and the Bureau of Economic Analysis. 

3. Understand Indicator Impact

So to understand how these indicators can impact the markets let’s say a release from the US Bureau of Economics showed a decline in housing numbers.

The negative news may prompt investors to sell the stocks of construction companies. Which will ultimately bring their stock value down.

Similarly, a lower US GDP number can negatively impact the US Dollar price against other currencies and when that happens you may plan to sell the US dollar.

Conversely, a better than expected GDP number would positively impact the US Dollar. At that point, you may think to buy the US dollars. So you need to understand the Forex exchange rates.

Why Forex Exchange Rates Fluctuate So Rapidly?

  • Sometimes the Forex exchange rates move more rapidly than usual. One example of why they move so rapidly is because of the multi-billion dollar companies. These multi-national companies operate in various countries offering goods and services in their local currencies. And frequently require to exchange a large amount of currency from one to another. 

1. Example

For Instance, let's say Toyota, the Japanese car manufacturer, sells 1 million cars to the United States. The US importers pay Toyota 15 billion US dollars. This gets deposited in Toyota’s US dollar account in Japan.

Now it's April and its tax season in japan. Toyota needs to pay 1 trillion Japanese yen in taxes; which is nearly $10 billion US dollars. This is a large amount even for Toyota.

Therefore, it'll have to convert its US dollars in Japanese Yen. Toyota will use the Forex market to sell $10 billion US dollars and buy the Japanese Yen.

At that time, the demand for the Japanese Yen will rapidly increase because a big player wants to buy a huge amount of Yen.

Naturally the US dollar demand will quickly go down as a huge amount of 10 Billion is being sold. Hence where Forex exchange rates come into play. 

2. Central Bank Interventions 

Central bank interventions are another reason for the huge fluctuation in the Forex market. The central banks pursue their country’s economic policies.

And they set their goals by adjusting the rhythm of demand and supply. They set the interest rates to adjust the value of their currency and to control inflation.

At the time when central banks intervene, it usually follows a huge fluctuation in the Forex market. The reason behind that is the investors and financial institutions also adjust to the new changes in the market. As they may liquidate their large existing positions or start opening new positions.

The huge fluctuation in the market provides traders the opportunity to enter and exit at a faster speed. But at the same time, it also increases the risk.

Momentum traders who are experienced generally wait and plan for these big moves. However, for new traders this style of trading can be very risky. So know your Forex exchange rates.

Forex Exchange Rates Conclusion

Forex exchange rates can be quite helpful in figuring out how different currencies translate to each other. The more you learn, the more you know.

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